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Inflation makes cash a hot potato for investors

Award winning financial writer Cherry Reynard writes for Glint on the risks faced by so many of us who hold cash savings. While ready money undoubtedly has its benefits, does holding too much cash mean you’ll get your fingers – and your savings – burnt?

Cash has long stopped being king. Central bank policy since the financial crisis has steadily depressed the interest rates available on cash savings, with the express aim of forcing people to take more risk with their investments. Cash savings are therefore likely to see investors lose money in real terms.

The long-term impact of holding a large savings pot in cash should not be underestimated. UK inflation for December sat at 3%, just down from a six-year high of 3.1% in November. The cost of goods and services has risen 78.7% over the past 20 years.

The top easy access savings account currently pays a rate of 1.31% (source: Savings Champion). Were inflation and interest rates to persist at these levels, someone with £100,000 pot, invested over 30 years, would lose around £40,000 in real terms. While regulators tend to focus on the cost of investments, the cost of cash should not be neglected.

However, this message has not been widely heard by savers. Cash ISAs still make up 77% of all ISA applications, and form the majority of people’s saving pots. People like the reassurance that the actual value of their pot doesn’t bounce around, as it might with a stock market investment, and that they can get hold of it at any time. Most do not consider that they are taking a risk by holding cash.

That said, few would argue for no cash at all. Most financial advisers would recommend having a few months’ expenses held in cash for a rainy day. But is there a place for cash in the rest of a portfolio?

Liquidity is a key selling point for cash: James Calder, head of Fund Research at City Asset Management, tends to hold a 3-5% in cash because the private clients he deals with tend to need cash to fund their lifestyles. Liquidity is also important for taking advantage of new investment opportunities. Calder says: “Cash has fallen out of favour in the last 10 years or so because it delivers a negative real return – people are losing money after inflation. That said, it is incredibly liquid and gives you some ‘dry powder’ in a portfolio, meaning that when you see an opportunity, you can move very quickly without having to sell your other holdings.”

Investors can’t stop inflation devaluing their money

While timing the markets is difficult and tends to be done poorly by investors, keeping some of a portfolio in cash gives investors ‘optionality’. Investors can pare back certain holdings when they have moved significantly higher, and reinvest in better value areas. As such, cash is an important source of flexibility within a portfolio.

Ready Money

It can also be a source of diversification, which may improve a portfolio’s risk-adjusted return. James Klempster, ‎head of Investment Management at ‎Momentum Global Investment Management, says that cash has zero correlation to other asset classes. “It isn’t subject to market moves and therefore provides some diversification. It can improve the efficiency of your returns and give a better portfolio outcome.”

This is particularly true in an environment where other low risk alternatives have become very expensive. Government bonds, for example, could lose investors’ money should there be a sharp spike in inflation and interest rate expectations. Investors may decide that they prefer the relative safety of cash to the prospect of losing money in other ‘safe haven’ investments.

The final reason to hold a lot of cash is if an investor is particularly bearish about the global economy. Certainly, there are reasons to worry – an unstable US government, high asset prices, the rise of alternative currencies. Over time, it has tended to be better to remain invested through difficult periods, but some investors may not want to take the risk.

There is a chance that this will change as interest rates rise. Will Hobbs, Barclays Wealth’s head of Investment Strategy, Europe, says that while cash’s role in a portfolio is primarily as insulation in current conditions, this may change: “It does start to get a bit more interesting on a strategic time frame, as central bankers try and wean their patients off the monetary drips and maybe even give us positive real interest rates.”

However, any significant rise in rates still appears to be unlikely. The UK yield curve still implies that rates will be below 2% in 30 years’ time and only 1% in five years’ time. Debt levels among developed markets – particularly the UK and US – remain high, and policymakers are unlikely to risk significantly increasing government debt repayments. As such, investors waiting for any significant change in savings rates could be disappointed.

Many UK banks were reluctant to pass on interest rate savings to their customers

At the same time, banks have shown themselves reluctant to pass on rate rises. In November, in the immediate aftermath of the UK rate rise, six of the major savings providers initially defied the calls from Bank of England Governor Mark Carney to pass the rate rise on to savers. At the same time, two of these banks had already hiked costs for mortgage borrowers. Higher interest rates do not necessarily lead to higher savings rates.

Paper dolls

If investors are going to hold cash, they need to do so carefully. If they are using savings accounts, it means targeting the higher paying accounts and be willing to switch regularly or hold cash over a number of accounts. For the time being, high headline rates for cash savings tend to be limited to regular savings accounts or for relatively low sums. As such, they are not a solution for larger sums of money.

They could also consider ‘near-cash’ options. Kempster says: “Investors do need to be aware that they don’t get anything for cash and as such, it’s a drag on the portfolio. They need to get cash to work as hard as possible. If they can bring themselves to take a little more risk, there are some options where there is a decent change of preserving value in real terms – i.e. after inflation.” He gives the example of short duration bonds, which have less sensitivity to the interest rate cycle. He says floating rate notes – where the coupon will move up and down with interest rates – may also be an option.

“Money market funds used to be an option,” says City Asset’s Calder. “But their weaknesses were exposed by the global financial crisis and now they pay next to nothing.” He suggests investors may want to look at some absolute return bond funds. These tend to aim for around 2% above cash with very low risk: investors are taking more risk than with cash but not significantly more, and they should beat inflation.

If investors are looking for a hedge against geopolitical uncertainty, cash is not the only option. It may be worth considering gold, which is also highly liquid but has a higher potential upside. Gold tends to be only lightly correlated with equity and bond markets and has shown a strong run since the start of December, largely on the back of a weakening dollar.

Too often, investors think holding lots of cash provides a safety net. The reality is that cash is risky. It has a place in a portfolio for flexibility and diversification, but there is an argument that investors can achieve that elsewhere – and with greater potential upside.

Cherry Reynard is an award winning financial journalist, who has written for the Financial Times, Forbes, Investors Chronicle, The Telegraph and Money Observer

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